India has a gold problem.
As the largest importer of gold in the world, India suffers from a current accounts deficit so severe (standing at 5.6% of GDP) that it threatens the economy. The Reserve Bank of India, India's central bank, cannot cut interest rates to stimulate the economy due to the CAD. Credit rating agencies are warning the government in New Delhi that, unless fiscal deficits and current accounts deficits are not addressed promptly, the nation risks a credit downgrade to junk status. Gold is the second-largest component of that CAD, behind oil.
The money Indian citizens spend on imports of gold coins, bars and jewelry leave the country and disappear from the economy. Reuters reports that experts estimate that the people of India have 20,000 metric tonnes of gold stored in their homes, far more than the U.S. Federal Reserve has. In an attempt to stem gold imports, the Indian government has raised import tariffs on gold from 2% to 6% in the last two years, and has also raised duties on unrefined gold. These added costs helped cut gold imports by 25% last year, but it was not nearly enough to stop the CAD from expanding. The new taxes have made gold smuggling, already a problem, much more profitable.
Now the central bank of India is considering more drastic measures according to Reuters, such as restricting gold imports by banks if the current account deficit remains at present levels. 60% of gold imported into India is through banks. But they are also looking at introducing gold-linked or gold-backed savings plans, as Turkey did last year. These measures have helped Turkey in reducing its current accounts deficit.
Turkey has a similar history of periods of hyperinflation, which has trained their citizens to hoard gold much as the Indians do. The Turkish central bank implemented some novel ideas in an attempt to coax the billons of dollars of gold back into the economy. Turkish banks are now allowed to hold up to 30% of their required reserves in gold, and to offer gold-based deposit accounts. This allows citizens to borrow against their gold which is held by the banks, which in effect reintroduces the gold into the economy. The results have strengthened the Turkish lira, lowered interest rates, lowered the current accounts deficit, and saved Turkish government bonds from being downgraded. These efforts have been so successful, that Turkey has had to take corrective measures: When the lira rose too fast, the central bank required banks to store more foreign cash and gold in reserve at the central bank, removing excess money from the system. (Read more in Adrian Ash's article on Market Oracle.)
The Reserve Bank of India hopes similar measures will help them. Strategies that it is pondering include gold-linked investment vehicles for private citizens as an alternative to hoarding physical gold; inflation-linked bonds; setting up a special bank to buy gold from Indians at higher than market rate; and removing incentives for banks to loan physical gold at a discount to large jewelers.